Weekending 28 October 2011


It is entirely clear that the ‘deal’ concocted by the 17 eurozone premiers and presidents at the Brussels summit and unveiled at 4am local time on Thursday 27 October is simply fancy and fantasy.

First one needs to sprinkle any analysis with large doses of ‘alleged’ – as in ‘alleged deal’, ‘alleged agreement’ ‘alleged action’, and ‘alleged welcome’ as in ‘We welcome Italy’s plans for growth …’

In the words of Wolfgang Munchau in the FT,

The day may yet come when the eurozone finally agrees a comprehensive package to end the crisis, but this was not the day.

The bounce on stock markets through Thursday was nothing much more than whistling past the graveyard and on the eve of Halloween weekend to boot – entirely appropriate and of course by Friday everything was beginning to feel eerie with markets beginning to go off and the alleged Italian plan looking more like The Italian Job.

Second the spectacularly disastrous condition of Greece – and what has caused this collapse – needs to be gleaned from the  communiqué. Third, the banks recap is smoke and mirrors while finally the general scheme of it all, EFSF2½, is imaginative fantasy in the tradition of that children’s tale, The Magic Pudding.

But first to return to the condition of Greece.


The communiqué content on an alleged proposed 50 percent haircut on sovereign debt agreed with the banks through the bankers’ global trade union the IIF, is not where the story is at. To believe so is to miss the mark – being the content of the troika assessment of 21 October (Greece: Debt Sustainability Analysis). What that document shows is the scale of disintegration and collapse to be faced by the Greek economy (and society) over the coming years and the scale of miscalculation and misrepresentation engaged in by the troika in the 18 months since they took charge. They have had their own auditors, experts, technocrats crawl quarterly (and for some time now daily) all over the Greek system – and still miscalculated … and misdiagnosed and mis-prescribed. Every aspect of the bailout to date has proved a gross failure.

The last [July] baseline scenario generated was bad and the 21 per cent haircut agreed with the IIF, had an impressive effect in the then modelling. The new baseline is utterly horrific. The 50 per cent haircut no more than gives Greece a fair chance of recovery (with favourable assumptions) but only with massive official support (read: lots and lots of IMF+EU conch shells) and only in the long term. These idiots now reckon Greece will not stand on its own feet until around the early 2020s at a pie in the sky debt level of 120 per cent (compared to a currently calculated current 180 per cent). All of this if to be achieved will require an entire new troika programme for Greece – thus the binning of everything prescribed, negotiated and insisted upon to date. As the communiqué puts it “We [the European Council] look forward to the conclusion of a sustainable and credible new EU-IMF multiannual programme by the end of the year.” Some hope! And a happy new year! Meanwhile Munchau in his FT column reckons,

I believe that Greece will require a much lower debt-to-GDP level, perhaps around 80 per cent, to achieve sustainability and access to market funding.

As to the banker-bondholders’ ‘voluntary’ haircut (the private sector involvement or PSI) well here it appears we can say two things. First 50 per cent is the bare minimum – which is to say it will have to be increased by an amount. Second the excess likely required depends on what the IIF ‘deal’ means to start with. Here Felix Salmon on his Reuters blog grips the crux,

The main thing which worries me about this plan is the sequencing: it seems that everything else is contingent on Greece getting its writedown first. And I’m highly skeptical that a 50% writedown from the banks is practicable or likely any time soon. I know the IIF has agreed in principle, but that doesn’t mean the banks are actually going to tender their bonds in practice. And if they don’t, does that mean the whole deal falls apart?

The write-down or PSI will proceed in Greece, there to finish off an already terminal banking system, requiring special resolution to have a remnant banking business bailed out (and nationalised) by the Greek state using … yes of course troika transfusion funds. Beyond the Greek banks though? Will ECB, IMF and other official holdings built up through market support and other operations (accounting for around a third of bond holders) suffer discounting? Trick or treat? And beyond these official holdings the uptake on the ‘offer’ simply will not be 100 per cent and will not be set at 100 per cent any more than was the case on the 21 July plan.

At which point the Peter Tchir question as one might put it goes live:

What about residual bonds that don’t get exchanged?  This is a real Problem

This is the real problem with a voluntary exchange.  What bonds are covered?  Are the bonds held by the Greek pension system covered?  If not, then you can see why banks would be reluctant to do anything that changes their status when one of the biggest holders isn’t affected.  What about bonds held by hedge funds?  And yes, believe it or not, hedge funds do own Greek bonds at these [current] prices.  Those bonds would not be affected by any voluntary exchange.  Even IIF members were only asked to do 90% of their bonds.  In the end, there will be [new Structured AAA Greek] SAG bonds and residual Greek bonds.  These residual Greek bonds create a lot of potential problems and conflicts of interest that not only are not being discussed, I now firmly believe, haven’t even been thought about.

Once the “voluntary exchange is done” what will happen to these residual bonds as they mature?  Will Greece pay them back at par?  If Greece is willing to pay them back at par, they will be rewarding those institutions outside of the IIF control (hedge funds in particular).  It will also encourage the IIF members to exchange as few bonds as possible and to hold on to the shortest dated bonds in hopes that Greece will pay them in full.  The deeper the “haircut” is (and the more real it is), the more IIF members have an incentive to find loopholes and keep as many residual bonds as possible.  It is a weird system, where bonds that don’t “participate” are treated in a better fashion than those that do.    

Tchir is right – not least on the hedge fund issue. GGBs are a vulture play. Munchau also robustly rubs it in,

I do not believe this is going to work. First, the agreement with the IIF is not binding on the banks. The IIF has yet to deliver the voluntary participation. Many banks would be better off if the haircut was involuntary, given their offsetting positions in credit default swaps. The whole point of a CDS is to ensure creditors against an involuntary default. By agreeing a voluntary deal, the insurance will not kick in. In other words, there is a significant probability that we will end up with an involuntary agreement – which is precisely the outcome the eurozone governments, except perhaps a small group of northern countries, had sought to avoid.

Is the ‘voluntary’ haircut, the PSI, a credit event? While ISDA seems to have decided to play along with all of this although Fitch has decided the PSI is an event and downgrade is likely on the way

An EU invitation to private investors in Greek government debt to exchange their bonds for new debt with a 50% lower notional value would likely result in a post-default rating in the ‘B’ category or lower depending on private creditor participation.

The new alphabet soup: the banking recap

… the whole alphabet soup of levered-up non-bank investment conduits, vehicles and structures acting in the irrational belief that there would be ever-rising home prices and that lenders would have unlimited access to money at low market interest rates.

Paul McCulley

Defining ‘shadow banking’ at

2007 Jackson Hole conference 

The second element in the alleged package is the alleged scheme to recap the banks. What it amounts to is a new ‘alphabet soup’, this time of alleged regulators and supervisors as well as unquestionably, bureaucrats and likely horse traders creating chaos. Paragraph 2 of Annex 2 of the communiqué describes the nightmare,

… a truly coordinated approach at EU-level is needed regarding entry criteria, pricing and conditions. The Commission should urgently explore together with the EBA, EIB, ECB the options for achieving this objective and report to the EFC.

The proposed funding mechanics are even more nightmarish than the ‘coordination’ regime:

Access to term funding is to be supported by (sovereign) guarantees;

  1. Quantitative capital targets are to be in place by 30 June 2012, to be
  2. 9 per cent “of the highest quality capital and after accounting for market valuation of sovereign debt exposures”; while
    • “Not affecting the relevant financial reporting rules” (i.e. avoiding accounting losses); and
    • Not leading to “excessive deleveraging”; and
    • “maintaining the flow of credit to the real economy” and
    • Banks to finance capital needs in the sequence: first private capital sources (including through haircuts); then if necessary, national governments (i.e. taxpayers/debt); and then failing such avenues, funding through the EFSF (for EZ countries only).

Smoke and mirrors … anyone … anyone? A bit reminiscent of the economics class in Ferris Beuller and the teacher’s distraught pleas,

In 1930, the Republican-controlled House of Representatives, in an effort to alleviate the effects of the… Anyone? Anyone?… the Great Depression, passed the… Anyone? Anyone? The tariff bill? The Hawley-Smoot Tariff Act? Which, anyone? Raised or lowered?… raised tariffs, in an effort to collect more revenue for the federal government. Did it work? Anyone? Anyone know the effects? It did not work, and the United States sank deeper into the Great Depression. Today we have a similar debate over this. Anyone know what this is? Class? Anyone? Anyone? Anyone seen this before? The Laffer Curve. Anyone know what this says? It says that at this point on the revenue curve, you will get exactly the same amount of revenue as at this point. This is very controversial. Does anyone know what Vice President Bush called this in 1980? Anyone? Something-d-o-o economics. “Voodoo” economics. 

The Magic Pudding – EFSF2½

 Come, come, this is no time for giving way to despair. Let us, rather, by the fortitude of our bearing prove ourselves superior to this misfortune, and with the energy of justly enraged men, pursue these malefactors, who have so richly deserved our vengeance. Arise!

Bunyip Bluegum,

The Magic Pudding

The great Australian painter (no laughter please) Norman Lindsay in 1917 published his children’s tale, The Magic Pudding, featuring the adventures of Bunyip Bluegum, Bill Barnacle and Sam Sawnoff and their magic pudding, Albert. The pudding was magical in that no matter how often consumed it simply replaced or refilled itself in order to be again eaten – a wonder of the world indeed. Our heroes were faced constantly with the Pudding Thieves, out to snaffle Albert for themselves. Thus our heroes constituted themselves the Noble Society of Pudding Owners (or as we might anoint them today, the NSPO) and set about fending off the Thieves or recovering Albert at Bunyip’s exhortations.

And so, by the fortitude of their bearing our eurozone premiers and presidents propose to go forth intent on proving themselves superior to our general misfortune and vanquishing those devils, those spirits of the living dead at our doors. The scheme of 21 July is now “fully operational”. Phew! It was a close-run thing. In the image of the magic pudding EFSF2½ will however often and much dipped into never empty, will always refill and its ingredients will never dilute, will ever retain the highest quality credential, the Triple-A status. The reality of course yet again is that there is nothing there – Hans Andersen Syndrome.

First it has been declared that the capacity of the extended EFSF [agreed on 21 July] can be enlarged without extending the guarantees underpinning the EFSF. An old-fashioned overcollateralised SPV a la the covered bonds model has been declared to be a leveraged non-bank. Two tricks are to be deployed by the NSPO EFSF: optional credit enhancement (an ‘insurance’ or first loss wheeze) and second the deployment of aptly named SPIVs.     

Credit enhancement is intended to reduce funding costs through liquidity risk insurance for sovereign bonds issued by Member States. But as Peter Tchir makes the point (his emphasis),

A “first loss” guarantee doesn’t REMOVE liquidity concerns, it may alleviate them, but since it is only a portion of the liquidity required, it does not remove them, furthermore, it only works while the “first loss” providers are deemed to be liquid. 

And Wolfgang Munchau opines,

Herman van Rompuy … made a revealing comment following the meeting when he said that the banks have been doing this forever. Why should governments not do so as well?

The reason is simple. Banks can only do this because central banks and governments act as ultimate guarantors of the financial system. There exists an implicit insurance of unlimited liability. In the case of the [EFSF] the very opposite is the case: there is an explicit insurance of limited liability. Germany wants its exposure capped to a maximum of 210bn. I doubt that global investors will rush into the tranches of the special purpose vehicle through which the eurozone wast to leverage the EFSF.

 This was written and published before the Spiegel on Friday reported that

Germany’s highest court has issued a temporary injunction banning the work of a new panel convened by the country’s parliament to quickly green-light decisions on disbursement of taxpayer funds through the euro bailout program. The decision could lead to further delays in German decision-making in efforts to rescue the beleaguered common currency. 

Germany’s Federal Constitutional Court on Friday expressed doubts about the legality of a new panel of lawmakers set up by the German parliament to reach quick decisions on the release of funds from the euro bailout mechanism, the European Financial Stability Facility (EFSF). The court issued a temporary injunction banning the nine-person committee in the Bundestag from taking any decisions on the deployment by EFSF of German taxpayer money.

 This amounts to … anyone … anyone? Bundesverfassungsgericht … anyone … anyone? “Risk”!

Looks like the NSPO EFSF has been bushwhacked: time for Rumpypumpy and all the other presidents – old and new – to do their Bunyip Bluegum imitation. But where’s Albert?

As to the SPV/SPIV mechanism or option and its interaction with the insurance wheeze, we leave the (almost) last word again with Tchir (his emphases),

 I have to admit I get a bit lost here, but I think there bizarre form of the insurance may be why Finally, a decision on which of Options 1 and 2 represents the most efficient use of EFSF resource can only be assessed after extensive dialogue with potential investors and rating agencies in any normal deal, this dialogue would have been ongoing, particularly with the rating agencies– and the answer may vary from Member State to Member State. Therefore, retaining the possibility to deploy both approaches would be beneficial. The plan to plan.

… with the final word here. Okay, okay – only a joke! However this is a moment of some note …

… so China enters the wacky and wonderful world in which Europe will promise the moon and the stars with the only backstop strategy that one of hope, more hope and nothing else.

We are confident this will all end the way good money chasing after bad always does.

… read more and more again.


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